Emerging Market Equities: Keeping it in the family

• Family ties make for a formidable force in both business and investing. It is an important consideration in uncovering attractive long-term investment opportunities within global emerging markets.

• Alignment of interests is key and selectivity crucial. Emerging markets present a distinctive context in which to operate a business, with constant evolution – and sometimes revolution – in economic, political, regulatory and financial conditions.

• The unique ownership structure of family businesses gives them a long-term orientation that traditional public firms can often lack. We believe the prudence shown by many family-controlled groups focused on intergenerational wealth accumulation supports long-term value creation for investors.

While wealth generation is a goal for all businesses, some family-controlled firms appear to place an equal emphasis on the goal of longevity. Each successive generation attempts to pass the baton to the next and maintain the good name and wealth of the family. We believe that this combination helps create a long-term and risk-aware approach that is very applicable to allocating capital in emerging markets.

Indeed, a recent independent study by Credit Suisse Research Institute validates what we have believed and experienced as investors. To quote Credit Suisse:

Family-owned companies outperform non-family-owned peers … they are supported by superior growth and profitability … they have a longer-term and conservative focus … they score slightly lower than non-family-owned companies when it comes to corporate governance … their succession risk may be overstated.

Our assessment suggests that the investment case for family-owned companies remains compelling as they have outperformed non-family-owned companies globally by around 400 basis points per year since 2006. Importantly, this impressive performance occurred in every region and sector of our analysis.”

Chart 1: Market cap-weighted sector returns

Source: Company data, Credit Suisse estimates

Unique ownership structure

The unique ownership structure of family businesses gives them a long-term orientation that traditional public firms can often lack. The cautious chief executive who balances both risk and reward will be fortunate to remain long at the head of a listed company. Since bonuses and share prices are often related, together they call for maintaining a certain head of steam in terms of business performance. Any diversion from maximising profits on a consistent quarterly basis is likely to lead to dismissal. Therefore, it is entirely rational for an executive management team to prefer to fail conventionally by following the herd and taking on too much risk, than to succeed unconventionally. For management teams whose remuneration and long-term wealth accumulation is levered to options and share awards, the risk/reward trade-off is asymmetric.

There’s a big difference between playing with “other people’s money” and the “family silver.”

For many, the phrase “family business” conjures up images of a small- or mid-size company with a local focus. This does not, however, reflect the reality or powerful role that family-controlled enterprises play in the world economy today. Not only do they include corporations such as Walmart, LG, Heineken, Tata Group and Porsche, but they account for more than 30% of U.S., French and German companies with sales in excess of US$1 billion, according to an analysis from Boston Consulting Group (BCG).

Family-controlled businesses are even more prevalent in emerging markets. Within Credit Suisse’s Family 1000 database, the majority of family-controlled businesses emanate from emerging markets, with “… Asia alone contributing 536 or 54% of the total.”

BCG’s separate and unrelated research corroborates Credit Suisse’s finding: they [family-controlled companies] account for approximately 55% of large companies in India and Southeast Asia and 46% in Brazil.

The significant presence of these types of businesses within our investment opportunity set, and our belief in the ability of such groups to generate wealth in a risk-averse manner, helps to explain the importance we place on researching controlling family groups within emerging markets. It also strongly contrasts with the composition of the MSCI Emerging Markets IndexSM. State-owned enterprises (SOEs) make up a substantial proportion of the index. By using a capitalisation-weighted index, the benchmarks appear to favor scale and political influence over returns and family-controlled enterprises. As discussed in our prior insight on the topic, The Dangers of Benchmark Investing in Global Emerging Market Equities, roughly a quarter of the companies in the emerging markets benchmark can be classified as SOEs – a factor that may expose passive investors to increased risks.

Selectivity is crucial

As noted earlier in the Credit Suisse study, not all family-owned companies practice good corporate governance. And that is why we insist that trust has to be earned over time and we do not simply make an assumption that a family owner will act in the common good and emphasise stewardship over greed. The high-profile case of Samsung Vice Chairman Jay Y. Lee allegedly paying government officials to gain government support for a merger of Samsung C&T and Cheil Industries speaks to the fact not all family-controlled firms create strong governance structures that protect minority shareholders. We test this premise through our fundamental, bottom up research, and we ask questions such as:

• How has the family treated its minority shareholders in the past?

• What businesses do the family own outside the listed entity and are there conflicts of interest?

• Are there good-quality independent board members providing oversight?

• Does the family conduct government-related business and if so how does it win contracts or licenses?

• How is the family regarded by non-financial stakeholders such as local communities and non-government environmental organisations?

These lines of inquiry help us form a view of quality over and above looking at historical financial returns. We want to see returns that have been generated in a risk-aware manner as this fits with our absolute rather than relative return approach to emerging markets investing.

Profiting from uncertainty

Another attraction of long-term owners, such as families, is their ability to make farsighted, sometimes contrarian decisions, that a professional management team more focused on short-term results and stock market pressure might not. A chief executive with a reduced time horizon can make decisions that are influenced by the short-term and often pro-cyclical moves of the stock market, which can hurt the long-term value of a business. This is particularly the case in commodity and cyclical sectors of the market. Antofagasta, a Chilean miner controlled by the Luksic Group, exemplifies countercyclical thinking of family-controlled companies that emphasise longer-term over shorter-term investment decisions.

In July 2015, Antofagasta announced the acquisition of a promising copper asset from a financially distressed seller. In contrast to many of its mining peers, Antofagasta had maintained a strong balance sheet throughout the last decade, and was able to act decisively as other miners facing pressure from a weakening copper price and highly levered balance sheets were forced to dispose of high-quality assets. This countercyclical behaviour is exactly how we believe mining companies should act but it requires a management team incentivised to resist short-term market pressures, which in this case the controlling family provides.

Chart 2: Family firms – risk aware

Source: Capital IQ and Bloomberg as of December 31, 2017.

Resilient businesses through market cycles

Controlling groups such as the Luksic Group tend to share our belief in a long-term approach to investment. They also put themselves in this position by being risk aware when it comes to the amount of debt that the business is willing and able to hold.

In modern corporate finance, a judicious amount of debt is considered a good thing because financial leverage maximises value creation through the leverage of returns. Family-controlled firms, however, often associate debt with fragility and risk. They believe debt means having less room to manoeuvre if a setback occurs and that it can also lead to being beholden to a bank or bond markets during periods of cyclical economic weakness. As a 2012 Harvard Business Review study states, “family-run companies [may not consistently] earn as much money as companies with a more dispersed ownership structure. But when the economy slumps, family firms far outshine their peers.” And when this study assessed business cycles from 1997 to 2009, it found “that the average long-term financial performance was higher for family businesses than for non-family businesses in every country [they] examined.”

We believe well-managed, family-controlled businesses are more resilient than non-family-controlled businesses because they emphasise balance sheet strength and capital preservation. Based on the Credit Suisse study, family-controlled businesses retain a higher percentage of earnings (i.e., lower payout ratios) and maintain more stable dividend payout ratios. Because of a higher earnings retention rate, they tend to be less reliant on external financing for capital expenditures or for supporting dividends.

Chart 3: Payout ratio comparison

Payout ratios of family-owned companies are about 13 points lower

Source: Company data, Credit Suisse estimates.

Ensure alignment of interests

Emerging markets present a distinctive context in which to operate a business, with constant evolution – and sometimes revolution – in economic, political, regulatory and financial conditions. The prudence shown by family-controlled groups with focus on intergenerational wealth creation may allow them to navigate these conditions in a manner that supports long-term value creation. Investing alongside families with good reputations that share our belief in a long-term approach to investment is, in our view, an important way to align interests as we seek to deliver “risk-aware,” superior returns for investors.

Published by Glen Finegan, Head of Global Emerging Market Equities, Janus Henderson